FOOL ON THE HILL
The Best of Charlie Munger

Charlie Munger, who runs Wesco Financial, is the famed right-hand man of Warren Buffett. He is also a master investor in his own right. At Wesco's annual meeting a week ago, he shared his always-blunt opinions on Berkshire Hathaway, the scandalous ethics in the accounting, law, and investment banking professions, and more.

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By Whitney Tilson
May 15, 2002

Warren Buffett is generally acknowledged to be the greatest investor ever -- one of the reasons why 13,000 people flocked to the recent annual meeting of his investment vehicle, Berkshire Hathaway (NYSE: BRK.A). But closely following Buffett are a handful of other legendary investors, including his long-time partner, Charlie Munger.

While Buffett gets all the attention -- and is, according to Munger, the superior investor -- Munger is himself an investment genius and, were it not for Buffett, might well be acclaimed the world's greatest investor. Before Munger joined forces with Buffett in the mid-1970s, his investment partnership compounded at an average rate of 24.3% annually from 1962 to 1975 (vs. only 6.4% for the Dow over the same period).

In addition to his role as vice chairman of Berkshire Hathaway, Munger is chairman of Wesco Financial (AMEX: WSC), which is 80.1%-owned by Berkshire. In a similar open-mike format as the Berkshire meeting, Munger answers shareholder questions for a couple of hours at the Wesco meeting. Since Buffett does most of the talking at the Berkshire meeting, I always like to attend the Wesco meeting to hear Munger's in-depth thinking. I wasn't disappointed this year.

As I did in last week's column on Berkshire's annual meeting, I will try to distill many pages of notes down to the most important things I heard. (My notes can be seen in their entirety at my website.) I've added a little commentary, but will generally let Munger speak for himself. Recording devices were not allowed in the meeting, so in many cases I am paraphrasing because I couldn't write quickly enough.

Berkshire's insurance operations
"I do think we get some advantage in reinsurance because people trust our willingness and ability to pay, so it's not a commodity. I think we have some special talents. That being said, I think it's dangerous to rely on special talents -- it's better to own lots of monopolistic businesses with unregulated prices. But that's not the world today. We have made money exercising our talents and will continue to do so.

"I'm glad we have insurance, though it's not a no-brainer, I'm warning you. We have to be smart to make this work.

"The overall result is that we're going to do pretty well -- meaning in the top 10% [of the industry] -- because we do different things....We're willing to do some unpleasant things.

"Generally speaking, we're mildly optimistic about our insurance operations." [This is Munger-speak for "I'm quite enthusiastic about our insurance operations."]

Berkshire's future outlook
"It's a finite and very competitive world. All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return.

"Personally, I think Berkshire will be a lot bigger and stronger than it is. Whether the stock will be a good investment from today's price is another question. The one thing we've always guaranteed is that the future will be a lot worse than the past."

Types of businesses Berkshire buys
"We tend to buy things -- a lot of things -- where we don't know exactly what will happen, but the outcome will be decent."

Would Berkshire ever invest in Level 3?
"We have the same problem as everyone else: It's very hard to predict the future [of Level 3 (Nasdaq: LVLT)]. Could we invest in it? Sure, it's conceivable. After all, we're in the electricity distribution business in the U.K. and the generating and distribution business in Iowa. We have a history when things are really horrible of wading in when no one else will."

Berkshire's culture
"For many of our shareholders, our stock is all they own, and we're acutely aware of that. Our culture [of conservatism] runs pretty deep."

Becoming a good investor
"If you're going to be an investor, you're going to make some investments where you don't have all the experience you need. But if you keep trying to get a little better over time, you'll start to make investments that are virtually certain to have a good outcome. The keys are discipline, hard work, and practice. It's like playing golf -- you have to work on it."

Investing mental models
"You need a different checklist and different mental models for different companies. I can never make it easy by saying, 'Here are three things.' You have to derive it yourself to ingrain it in your head for the rest of your life."

Circle of competence
"There are a lot of things we pass on. We have three baskets: in, out, and too tough...We have to have a special insight, or we'll put it in the 'too tough' basket. All of you have to look for a special area of competency and focus on that."

Buying into stock declines
"Over many decades, our usual practice is that if [the stock of] something we like goes down, we buy more and more. Sometimes something happens, you realize you're wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices."

Wall Street's ethics (or lack thereof)
"The ethics of Wall Street will always average out to mediocre at best.... This doesn't mean there aren't some wonderful, intelligent people on Wall Street -- there are, like those in this room -- but everyone I know has to fight their own firm [to do the right thing]."

Critique of legal and accounting firms
"Too many law and accounting firms get roped into shady things. For example, tax shelters, with their contingency fees and secrecy, are a total abomination.... I never have the least interest in defending miscreants and helping them misbehave. But the general view is that it's wonderful what Johnny Cochran did."

Derivatives
"Everyone caved, adopted loose [accounting] standards, and created exotic derivatives linked to theoretical models. As a result, all kinds of earnings, blessed by accountants, are not really being earned. When you reach for the money, it melts away. It was never there.

"It [accounting for derivatives] is just disgusting. It is a sewer, and if I'm right, there will be hell to pay in due course. All of you will have to prepare to deal with a blow-up of derivative books.

"It's a crazy idea for people who are already rich -- like Berkshire -- to be in this business. It's a crazy business for big banks to be in."

Risks of financial institutions
"The beauty of a financial institution is that there are a lot of ways to go to hell in a bucket. You can push credit too far, do a dumb acquisition, leverage yourself excessively -- it's not just derivatives [that can bring about your downfall]."

Universities
"There's a lot wrong [with American universities]. I'd remove 3/4 of the faculty -- everything but the hard sciences. But nobody's going to do that, so we'll have to live with the defects. It's amazing how wrongheaded [the teaching is]. There is fatal disconnectedness. You have these squirrelly people in each department who don't see the big picture."

Thinking sensibly
"The ethos of not fooling yourself is one of the best you could possibly have. It's powerful because it's so rare.

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.